Primary Dealers & Market Making

SEACEN/WB/IMF Conference Hosted by the Central Bank of Sri Lanka Colombo, June 2004 Thordur Jonasson
Financial Sector Operations & Policy Department

June 9, 2004

Structure of presentation
1. 2. 3. 4. Role of financial markets Primary market Primary dealers Market Making

Financial Sector Operations & Policy Department

Pricing of Risk in a Liberalized Financial System - I

The main role of the financial markets is to price risk This may be complicated by:
Lack of fiscal discipline High inflation expectations Lack of policy consistency Lack of transparency of public finances Lack of coordination

Financial Sector Operations & Policy Department

Pricing of Risk in a Liberalized Financial System - II

Leading to:
Variability in demand for bonds which would attribute to extreme volatility in interest rates Greater reliance on short-term maturities

Expectations of market participants may be dominated by memory of great volatility Credibility will be attained with consistency over time
Financial Sector Operations & Policy Department

Impact on Development
Issues
Ad-hoc or no debt

Result

Long-term Impact

management strategy Debt Management Weak capacity Accountability is unclear Access to Primary Market Debt Markets Illiquid money market Custody & Settlement problems

Higher Risk

Greater risk of macro instability

Government budgetary pressures Higher Cost Higher cost of funds to productive sector, SMEs, etc. Less access to funds
Higher growth can be achieved by addressing the causes of unnecessarily high risk and cost

Financial Sector Operations & Policy Department

The organization of primary markets - I

Common questions:
What is the most efficient way to sell bonds? What types of investors do we want to reach? How can we increase competition in the primary market? Should we implement a primary dealer system? Should we have a special distribution channel for retail / small order clients ? Should we allow non-competitive bidding?
Financial Sector Operations & Policy Department

The organization of primary markets - II

Distribution options:
Auctions Direct sales using new technology Private placements/syndication Tap-sales Announcing a price and soliciting public subscription over a fixed period Announcing a price and offering sales on tap over an unlimited period altering the price with varying frequency
Financial Sector Operations & Policy Department

The organization of primary markets - III

Issuers User of capital
Intermediaries - provide liquidity - access to investors

Investors Suppliers of capital

Regulation and supervision. - The Central Bank, - The Government - Self Regulatory Organizations

Market infrastructure - trading systems - information systems - brokers - clearing, settlement & custody

Financial Sector Operations & Policy Department

Primary dealers I
May assist change to a market-based funding environment
Branch networks (bank-based) Operators of mutual funds Business relationships with institutional investors such as pension funds and life insurance Links to off-shore investors

Principal / Agent issue

Financial Sector Operations & Policy Department

Primary dealers - II
There are no international standards for Primary dealers and the term itself can be misleading
Some financial systems may be less suitable for primary dealers
Will the introduction of primary dealers lead to deeper and more liquid markets? Rent seeking vs. gain from a more deeper liquid market? Can the arrangement be removed or reduced through competition in the future?

Financial Sector Operations & Policy Department

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Primary dealers - III

Functions performed may include:
Acting as a channel between debt manager and investor in the primary market Performing as bookmakers and distributors by having dealers that canvass investors interest Acting as providers of immediacy of liquidity to primary and secondary markets Acting as providers of asset transformation and market making services by being willing to hold inventories of government securities
Source: IMF MAE OP/02/02
Financial Sector Operations & Policy Department

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Primary dealer systems Rights primary market

Exclusive or privileged access to primary auctions Exclusive or privileged counterparty for central banks open market operations Exclusive or preferential access to noncompetitive bids Information and consultation with the government debt management agency Borrowing privileges with central bank, including repurchase agreements Exclusive or privileged counterparty for operations with public debt manager Underwriting commissions Usage of the title primary dealer

Financial Sector Operations & Policy Department

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Primary dealer systems Obligations primary market

Bid in auctions Minimum underwriting obligation Providing authority with market information and analysis Participation in money market operations Compliance to prudential regulation, i.e. a Code of Conduct Participation in research Position reporting to supervisory authority
Financial Sector Operations & Policy Department

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Primary dealers systems Examples

Country
Canada

#
12

Rights/Privileges
Exclusive counterpary rights for central banks omos and borrowing privileges with the central bank Exclusive access to primary aucitons Exclusive access to primary auctions Consultations with the debt management agency Exclusive access to primary auctions and noncompetitive bidding

Obligations
To bid in auctions. To make firm two-way quotes To report to the central bank To bid in auctions. To make two-way quotes To bid in auctions. To make firm two-way quotes. To report to the debt agency. To bid in auctions. To make firm two-way quotes. To trade a minimum of 2 percent of total secondary market volume

Greece Hungary Korea

15 13 26

New Zealand
Sweden 7 Exclusive access to primary auctions and counterparty to central banks omos

none
To bid in auctions. To report to the central bank. To contribute with good liquidity in the market

Thailand
UK

9
17

Exclusive counterparty to central bank omos

Exclusive access to primary auctions and participation in consultation meetings, secondary market dealing with the central bank Exclusive counterpart to central banks omos. Ability to borrow securities intraday form central banks portfolio.

To make two-way quotes

To make firm two-way quotes. To report to the central bank. To report trades to the LSE To bid in the aution (non-contractual obligation) To report to the central bank To participate in the Federal Reserves omos To provide the Fed with market information and analysis

USA

25

Financial Sector Operations & Policy Department

Source: IMF MAE WP/03/45

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Primary markets Impediments to development - I

Issues related to debt management
Number of bond series issued Number of issuers Instrument design Using long term instruments for cash management Auction frequency

Deciding on instruments and issues very shortly before each auction

High level of market uncertainty regarding amounts and pricing Auction process non-transparent

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Primary markets Impediments to development - II

Payment and settlement infrastructure Prepayments Low capitalization of primary dealers Issues related to monetary policy implementation Unrealistic obligations and lack of incentives for primary dealers Weak investor base
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Secondary market
Why should an issuer be concerned about secondary market activity?
The more liquid a security is, the easier and less costly it is for an investor to sell, and therefore the lower the liquidity premium attached to the security when issued Public good aspect

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Secondary market Organization

Offshore investors Central Bank Retail investors Speculators

INTERMEDIARIES

non pricemakers

pricemakers

Commercial Banks

Commercial Banks Discount Houses Institutional investors Merchant Banks

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Financial Sector Operations & Policy Department

Secondary markets Primary dealers obligations

Market making Promotion of debt among retail investors Assisting in the development of the government securities market Providing government securities closing prices and volumes

Financial Sector Operations & Policy Department

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Secondary markets Market making

Parties agree to make prices to each other for the purchase and sale of financial assets. Prices are made:
during pre-agreed times in agreed volumes with agreed buy / sell spreads Quality of pricing should be monitored on an ongoing basis

Financial Sector Operations & Policy Department

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Market making
Market making is a risky business - assets can be bought / sold at short notice
Events may result in loss of liquidity In turbulent markets spreads widen, and in extreme cases price making may cease

Not all financial institutions may have the capacity to be market markets
Two-tier system

Important to define when quotes can be suspended

Monitoring the bond market on an ongoing basis

Financial Sector Operations & Policy Department

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Market making Initiating

It may be necessary to offer incentives to Primary Dealers (although this is not ideal in the long term) Incentives may include:
Access to interdealer broker Access to non-competitive bids Securities lending Access to buybacks/switches Backstop facilities (should be carefully designed) Cash remuneration for Market making?

Financial Sector Operations & Policy Department

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Market making Non-competitive bids

Preferential access by primary dealers to ensure that they will get debt stock
Ratio of non-comp bids ranges from 0 to 40% May include a discount May be in the form of an option to buy the day(s) post auction

Retail distribution
Labor intensive May require prepayment

Central bank
Financial Sector Operations & Policy Department

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Market making Securities lending

Allowing short positions can reduce dealer inventories and sustain business during rising interest rates
Debt manager creates stock and retires Pricing of facility Can be made cash-neutral by receiving collateral of other government securities Collateral practices may need to be strengthened when transaction volume increases an MRA is important
Financial Sector Operations & Policy Department

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Market making Buybacks/switches

Buybacks
used to manage refinancing risk by reducing maturity concentration change debt portfolio composition

Switches
Offered at the discretion of the debt manager or by reverse inquiry Sophisticated debt management tool

Buybacks and switches increase secondary market activity

Requires a transparent debt management strategy Avoid speculative/manipulative behavior at all costs
Financial Sector Operations & Policy Department

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Market making Backstop & Cash compensation

Backstops
Not widely used Could encourage excessive risk taking by Market makers Could subject the government to liquidity risk

Cash Compensation has been used while developing markets

Fees for primary market participation Fees for market making
Financial Sector Operations & Policy Department

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Market making Impediments to development I

Tap issues
If securities are freely available on tap or if auctions are frequent, there is little incentive to trade on the secondary market

High liquid asset ratios

result in institutions holding more assets than they desire.

Investor base
Small institutional investor base not motivated to manage their risks or a reasonable sized investors base but concentrated

Financial Sector Operations & Policy Department

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Market making Impediments to development II

Small number of dominant market participants
possible collusion and lack of competition

Weak market participants Poor payment and settlement systems

high settlement risks deter trading

Interbank credit lines too small for trading

irregular and uncertain issuance pattern difficult for investors to form expectations about future supply

Financial Sector Operations & Policy Department

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Market making Impediments to development III

Poor price discovery mechanisms
developed markets have published prices, much in the same way as for shares.

No hedging mechanisms
no access to rental securities undeveloped repo markets

Poorly defined trading conventions

no codes of conduct

Taxes
eg taxes based on original discount value, transaction taxes, withholding taxes

Financial Sector Operations & Policy Department

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Primary dealers Closing remarks I

Evaluate whether potential benefits of a primary dealer system outweigh the costs
Is the macroeconomic environment stable? Is the microstructure of the issuance strategy sufficiently well designed? Is the investor base diversified and does it promote liquidity and stabilize market demand? Are there competitive, capable and capitalized intermediaries present? Is there a business case for being a primary dealer?

Some countries have not found it necessary to introduce a primary dealer system
Financial Sector Operations & Policy Department

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Primary dealers Closing remarks II

There is a greater chance of development where banks have to manage their own liquidity and there is a competitive market for longer term savings
Segregation of investment and trading portfolios Mark-to-market, valuation principles

It is not given that primary markets for Tbills and Tbonds should be treated alike The government has an important role to play both as the client and as the regulator and supervisor

Financial Sector Operations & Policy Department

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Thank you!
Questions/comments/suggestions to:
Thordur Jonasson tjonasson@worldbank.org (202) 458-2165

Financial Sector Operations & Policy Department

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